The Concept of Substance in a Post-BEPS World

Luxembourg is a prime holding location and a major financial center that features a large fund industry. Whenever Luxembourg companies are involved in cross-border investment and business activities, the question arises regarding the right level of economic substance. Substance requirements may exist for different reasons, may be more or less clear, and need to be determined case by case. This article analyzes the importance of substance in an international tax environment that has been reshaped by the OECD’s base erosion and profit-shifting project.

The importance of substance is well known, and awareness has only increased as a result of the BEPS project. From a Luxembourg tax perspective, substance is necessary to properly manage the tax residency of companies. Luxembourg companies performing financing activities must comply with specific substance requirements set out in the Luxembourg transfer pricing circular. Luxembourg companies that are subject to the oversight of the supervisory body of the financial sector (Commission de Surveillance du Secteur Financier, or CSSF), must comply with regulatory substance requirements (especially fund management companies).

Luxembourg companies that are part of an international investment structure or are members of a multinational group may have to comply with an increased level of substance to be out of reach of antiabuse legislation provided under jurisdictional tax laws and tax treaties concluded by Luxembourg. In the EU, however, those substance requirements must be consistent with EU law as interpreted by the Court of Justice of the European Union.

Substance may also be required from a transfer pricing perspective, given that the application of the arm’s-length principle relies on several concepts that are closely linked to substance. Also, the economic reality must be consistent with the fact pattern described in the transfer pricing analysis. Finally, a lack of appropriate substance can be a source of reputational risk.